Have the last laugh

Retirement funding will be an increasingly nagging problem for future generations. Peter French, a partner at Troy French and Partners, explains how equity release might be harnessed to help solve income and inheritance tax issues.

Will future generations ever retire? Will the future for most mean dying in harness? At the very least, people are likely to have a much less secure retirement.

Look at the facts. Annuity rates are probably 40 per cent lower than 10 years ago. Compare the man who has just reached 65 with the one who reached 65 in 1997. In real terms, his pension is probably about a third of the 1997 level.

Increased longevity, tax on pension income, Chancellor Gordon Brown’s removal of the dividend tax credit on pension funds and the performance of the FTSE 100, which is still below March 2000 levels, have conspired to hurt those with money-purchase schemes. Pension saving has reduced and many big defined-benefit schemes have closed.

The cost of living for the elderly is deliberately understated by using the harmonised index of consumer prices instead of the retail prices index. Essentials of living such as council tax, water, gas, electricity and food escalate faster than non-essentials.

The elderly increasingly have big credit card debts and mortgages in retirement. Broken marriages and dysfunctional family situations reduce stability and lower the income of particularly women whose pensions suffer more from marriage break-up.

Single-person households are more common which bodes ill for retirement funding. More pensions are owned by older men with shorter life expectancy, who leave behind impoverished widows, adding to the problem of declining secure marriages which have traditionally helped to secure incomes for older women.

Working later is inevitable. Increases in longevity and a declining birth rate will raise retirement funding costs so retirement will need to be at 73, if the proportion of gross national product taken by the non-productive oldies is to remain at present proportions. Lord Adair Turner suggested as much when he became chairman of the committee to look at retirement funding.

It seems as though it will become the norm to work until retirement to clear the mortgage, only to take equity release after a few years to provide income. Equity release will be the saviour for many impoverished pensioners but I believe there is a combination of inadequacies with the design of these arrangements.

They normally have big early redemption penalties which causes problems when downsizing becomes necessary, perhaps because a spouse has died. Some early redemption penalties are alarming should gilt yields or the base rate fall. Many plans have restrictions on a couple holding a house as tenants in common, making inheritance tax planning more difficult.

Suppose the householder wants to spend more than six months out of the home, maybe overseas. They will be in breach of their mortgage covenant. They cannot let the home temporarily if they want to spend, say, six months here and six months overseas.

The fact that so many lenders fail to offer an income plan makes the plans unattractive to those needing primarily income rather than releasing a lump sum. The loss of rights to such benefits as minimum pension income and council tax assistance, where a regular income or big lump sum have been released, can cause a serious catch22 situation.

Some plans offer ad hoc drawing rights as and when sums are required, say, in £5,000 tranches. These may reduce the risk of loss of state benefits.

Individual desirable features appear in many plans but no plans have them all, making the decision more vexed.

Issues such as older children coming back to live in the family home after a marriage break-up or ill-health can also be a serious breach with some lenders.

The adviser in this market has a lot to consider to provide the arrangement with the most appropriate and, shall we say, the least bad selection of features.

An unmarried couple or, say, two sisters with an equity release plan could face an enforced sale after the first death to pay IHT on the estate of the deceased co-tenant in the house. Nil-rate band discretionary trusts may also look less attractive following the recent Phizackerley case.

Despite these reservations, there is a real place for equity release in retirement planning.

Debt is good. If a house is mortgaged with a regulated lifetime mortgage, or perhaps a suitable home reversion plan, and the assets so released placed in a suitable trust such a discounted gift trust, then the debt on the house rolls up to reduce IHT liability in the event of the second death while the assets will be in a trust which will take the money out of the estate after seven years.

There will normally be a significant discount or reduction in the IHT liability immediately, according to age and assuming normal health.

Income from the trust will probably be tax-free for many people if limited to 5 per cent. However, a spouse with income below a personal allowance could take more. Access to the trust capital is denied in return for income, which is why it works.

That income may be the solution to lack of pension income for our impoverished pensioners with inadequate income but a valuable home. It solves the uncertainties relating to nil-band trusts and possible attack by the HM Revenue & Customs. It ensures that the IHT liability is reduced.

What might go wrong? There is a risk – systemic of holding equities – which can be deemed to be necessary for growth in investment value. Remember the 2000 to 2003 stockmarket slide? There is a need for a carefully balanced investment portfolio relating to client risk and the long-term interest of trust beneficiaries after the settlors of the trust have died.

Variations, especially for younger homeowners, may include the use of a gift and loan trust which takes longer to remove money from an estate but allows for access to capital, unlike discounted gift trusts.

If we see widespread HMRC attacks on spouse nil-rate discretionary trusts or the like, then the above approach may solve many problems in one swoop. Financial planning is a very integrated and inter-reactive range of issues.

Combinations of plans, used correctly, may help solve the problems of inadequate pensions by using house price inflation to facilitate equity release, which can also help to solve IHT problems.

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